Berkshire and the Sokol Scandal: The Final Word

If you clicked on this headline, I'll assume you know at least some of the background to the story of Bershire Hathway (NYSE: BRK-B) executive David Sokol's resignation and Lubrizol (NYSE: LZ) stock trades; if you don't, you can find it here. Now that some of the dust has settled, it's worth trying to draw some lessons from this debacle.

Did Sokol engage in insider trading?The reader comments I have read on the story on this site and others suggest that many (perhaps even most) people assume that Sokol's trades are a clear-cut case of insider trading. However, readers who take the time to familiarize themselves with the relevant securities laws will find that it's difficult to assert with any confidence that this is a case of insider trading. (I can already see the aggressive comments accusing me of being a corporate shill and an agent of "big money.")

Does it matter?In this case, the problem is less with the nature of Sokol's actions than with their appearance. Perception creates its own reality, and I'll be the first to say that appearances in this case are downright awful. One need only apply a test that is contained in Berkshire Hathaway's Code of Business Conduct and Ethics:

When in doubt, remember Warren Buffett's rule of thumb: '... I want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper -- to be read by their spouses, children and friends -- with the reporting done by an informed and critical reporter.'

Sokol's actions made the front page of at least one national newspaper. I think it's fair to say that it has generated significant controversy, and the effect on Berkshire Hathaway's reputation isn't positive. By that standard, then, he made an error in judgment.

Sokol's defenseSokol's public defense turns on the fact that he had no knowledge of whether Buffett would be interested in acquiring Lubrizol (he came back to this incessantly in Thursday's interview on CNBC). However, inasmuch as Sokol had a role in sourcing and qualifying potential acquisition targets for Berkshire, it seems to me that should be enough to disqualify him from investing in any company he brings to Buffett's attention, regardless of whether he had any input into the decision to acquire a company and whether he thought Buffett would ultimately proceed with an acquisition.

We know that Buffett himself believes that the appearances are, in this case, unflattering. How do we know this? The very fact that Berkshire decided to get out in front of the story by disclosing Sokol's trades before they became a matter of public record as part of the acquisition process. That is an implicit admission that they knew this news would be not be well-received or would, at the very least, be controversial. Duing the CNBC interview, Sokol himself said:

I thought full disclosure was a good thing. And the purpose there was [that] my ownership would come out 30 or 60 days from now when the voting takes place on [the Lubrizol] transaction. And we did not want people to look back and say, 'Why didn't they tell us that?' So it's out there.

Why would the public react that way unless it felt the share purchases were problematic?

Does this affect Berkshire's value?With regard to Sokol's resignation, my initial reaction was that the loss of a talented executive and the front-runner to succeed Buffett was very significant. However, his lack of judgment in this matter and his seeming inability to understand what the fuss is about suggest to me that, despite a fantastic business career, he was not the right man for the highly visible role of Berkshire CEO. Furthermore, the company has a solid bench of candidates for the top post.

Will this incident make CEOs and boards of publicly traded companies more reticent to tie up with Berkshire in the future? Perhaps, but I doubt it. I would guess that being associated with Berkshire Hathaway is still viewed as being overwhelmingly positive.

I think the effect on Berkshire's long-term value is minimal. However, it comes at an inopportune time for Buffett. The crisis has not been kind to his reputation; it seems to be a fairly common view that his "bailout" investments in Goldman Sachs (NYSE: GS) and General Electric (NYSE: GE) were somehow improper. I don't share this view, but it is out there. Sokol's trades and the fact that Buffett has not openly rebuked him may reinforce the (mistaken) notion that Buffett is just another big-money insider who plays by his own rules.

Maintaining perspectiveIt's worth keeping this matter in perspective: It's unfortunate and Buffett should address it internally, but it should not be allowed to overshadow the fact that Buffett and Berkshire Hathaway remain wonderful examples for the business and philanthropic communities.

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Sokol never intended to become Berkshire's CIO; he tried to resign two years ago. Skimming $3m off the LZ acquisition on the way out is analogous to what 4.9-year-vested MSFT employees used to call their "F*U money," pardon the phrase - at 5 years their stock options vested, they'd cash in and move on. If I were about to retire, $3m to finance the acquisition of a nice home to retire to would seem quite appealing; nor do I believe the frankly ridiculous comments that "to a man of Sokol's wealth $3m is not a lot of money." $3 million liquid in one transaction for no risk is indeed a lot of money to someone of Sokol's mindset.

Buffett's 2011 shareholder letter contains a nice postscript dealing with behavior that might appear unethical; penned right around the time these shares were being traded. Buffett also just hired a (comparatively) young investment gun, Todd Combs, which may have made it clear to Sokol that his services were no longer really required. If so, this is one way of flipping the bird on the way out!

As far as the GS bailout money, why wasn't I offered the opportunity to pay for and receive GS preferred with a 10% annual return in Sep 2008? Makes a mockery of the idea of GS as a 'public' company, which it certainly is not, despite their legions of shysters employed to give the appearance of compliance with SEC regs.

<<Buffett also just hired a (comparatively) young investment gun, Todd Combs, which may have made it clear to Sokol that his services were no longer really required.>>

On retirement/ death, Buffett is splitting his role into two: An operating CEO, who oversees Berkshire's businesses, and a CIO, who is responsible for Berkshire's investment portfolio. Sokol and Todd Combs were not being considered for the same role, so the hire of Todd Combs had no relevancy with regard to Sokol's position within the organization.

<<As far as the GS bailout money, why wasn't I offered the opportunity to pay for and receive GS preferred with a 10% annual return in Sep 2008?>>

Because, contrary to Warren Buffett, nobody knows who you are and your investment wouldn't have added any credibility to the notion that the company is a viable enterprise that will ride out the crisis.

Sokols liability as an insider trader depends on whegther at the time he purchsed Lubrizol shares he intended to recommend its acquisition by Berkshire. Bear in mind that when Citi Group sent him data re Lub. as a possible investment it did so, according to the WSJ, in his capacity as a big Berhkshire wheel. To me at least this raises a legitimate presumption that he had this intent at the time he purchased the stock.

There is another issue here, not much discdussed. He must have amassed considerable data re Lubrizol before he made his purchase, and during his first pre-purchase discussion w. Lub's CEO. IN my view he had a duty to pass this info on to Berkshire, given his high up psoition there. ag besser